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Parker-Hannifin Corporation (NYSE:PH)

F1Q2013 Earnings Call

October 19, 2012; 11:00 a.m. ET

Executives

Don Washkewicz - Chairman, Chief Executive Officer & President

Jon Marten - Executive Vice President & Chief Financial Officer

Pamela Huggins - Vice President & Treasurer

Analysts

Joel Tiss - BMO

Stephen Volkmann - Jefferies

Eli Lustgarten - Longbow Securities

Mick Dobray - Robert W. Baird

Alexander Blanton - Clear Harbor Asset

Andrew Casey - Wells Fargo

Linda - Credit Suisse

Nathan Jones - Stifel Nicolaus

Jeff Hammond - KeyBanc

Henry Kirn - UBS

Operator

Good day ladies and gentlemen and welcome to the first quarter 2013 Parker-Hannifin Corp earnings conference call. My name is Erica and I will be your coordinator for today. At this time all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (Operator Instructions).

I would now like to turn the presentation over to your host for today’s call, Ms. Pamela Huggins, Vice President and Treasurer; please proceed.

Pamela Huggins

Thanks Erica. Good morning everyone. As Erica just said, its Pamela Huggins speaking and I’d like to welcome you to Parker-Hannifin’s first quarter fiscal year 2013 earnings release teleconference.

Joining me today is Chairman, Chief Executive Officer and President, Don Washkewicz; and Executive Vice President and Chief Financial Officer, Jon Marten.

For those of you who wish to do so, you may follow today’s presentation with the PowerPoint slides that have been presented on Parker’s website at www.phstock.com. For those of you not on the line, the slides will remain posted on the company’s Investor Information website at www.phstock.com, one-year after today’s call.

At this time I would ask that you reference slide number two in the slide deck, which is the Safe Harbor disclosure statement addressing forward-looking statements, and as usual ask, if haven’t already done so, please take note of this statement in its entirety.

On slide three, this slide as required indicates that in cases where non-GAAP numbers have been used, they’ve been reconciled to the appropriate GAAP numbers and are posted on Parker’s website at phstock.com.

Again, to cover the agenda for today on slide number four, the call will be in four parts. First, Don Washkewicz, Chairman, Chief Executive Officer and President will provide highlights for the quarter. Second, I’ll provide a review, including key performance measures of the first quarter, concluding with the revised 2013 guidance. The third part of the call will consist of the standard Q&A session; and for the fourth part of the call today, Don will close with some final comments.

So at this time I’ll turn it over to Don and ask that you refer to slide number five titled First Quarter Fiscal Year ‘13 highlights.

Don Washkewicz

Thanks Pam and welcome to everyone on the call. We certainly appreciate you joining us today. I just want to make a couple of comments and then we’ll turn it back over to Pam for some additional detail about the quarter.

First of all, our results in the first quarter largely reflect the impact of the continued weakness in international markets and the softness in North America and that’s particularly late in the quarter and I’ll talk about that in a minute here.

Actually I had a plan going into September, so July and August were actually fairly strong months. We are actually ahead of plan than we experienced in September; a lot of cancellations and rescheduling of orders and so forth by many of our OEM customers as they adjusted to current economic conditions. So that’s really what impacted the quarter for the most part. We were ahead and then a lot of these cancellations, rescheduling. We saw a September come in weaker than what we had anticipated.

Considering what happened in these conditions, we have performed well in the quarter or remain cautious about the outlook, especially going into calendar 2013 and I just say it to keep in mind that we are one of the few companies giving guidance into 2013 due to our mid-year fiscal. Our earnings guidance therefore reflects this caution with regard to the global economy in calendar 2013.

Just a few points about the quarter, a little review of the quarter. Our sales were essentially flat with last year at $3.2 billion and they were impacted by a 9% decline in industrial international sales, so you can see where the weakness is coming from; its in our international segment.

This is the third consecutive quarter in which we have reported a year-over-year decline in this segment, largely as a result of recessionary conditions in Europe and moderating growth in Asia. So really Europe was impacted the most and that followed by Asia. That was partially offset by a 5% growth in North America in the quarter.

Currency was negative 3%, while acquisitions contributed 3% and organic sales were essentially flat and that combination resulted in a flat top line for us for the quarter.

Total segment operating margins were 14.4%, which were actually pretty good when you look historically, they were pretty good numbers, in spite of all of the negative segments that we are talking about here and we are again impacted by the industrial international segment, which had operating margins of about 12.9%, while industrial North American margins remained pretty strong at 17.9%. I might just point out that North America margins were better than our full year North American margin last year, which was at 17.2%. So North America performed very well in the quarter.

Net income for the quarter was $239 million or $1.57 per share and that’s a decline of 18% compared with last year’s first quarter and that EPS reflects additional acquisition integration costs and we’ll talk about that in a bit, as well as aerospace R&D expense. I might add there that the additional expense for aerospace was required to keep pace with our customers timelines for several of these new programs that we’ve been working on, that we landed over the last couple of years, so that’s what impacted the R&D expense. Net cash from operations was slightly negative driven by a $226 million discretionary contribution to the pension plan and this anticipated change was announced previously.

During the quarter we also continued to execute on long term initiatives to drive growth and profitability, some of those were as follows: we completed five acquisitions in the quarter, which added $243 million approximately in annualized sales. Additionally in October we announced two more acquisitions, two filtration acquisitions and those were at about $141 million in annualized sales.

In addition we announced the divestiture of the automotive air conditioning portion of the climate industrial control segment and that the sales for that segment that we divested was approximately $140 million in sales. That unit by the way was in our numbers for the entire first quarter, but will not be going forward.

Earlier this month in France we saw a graded opening of our 2000th Parker store. We added 1000 stores in the past five years. We’ve added a store approximately every business day over the past five years somewhere in the world. So a lot of good things happening from the standpoint of acquisition activity and other growth initiatives for the company.

Looking forward to our expectations for the full fiscal year, we have revised our guidance for earnings for continuing operations from the range of $7.10 to $7.90 to the range of $6.15 to $6.75 per diluted share and that’s basically reflecting what we see right now.

As the year unfolds and we get another quarter end, we’ll have a better look at the next calendar year. At that time I think the elections will be over and maybe some of that things will calm down a little bit and we’ll see what impact that might have going forward. But right now we felt comfortable going with this range. We’ll adjust that as we deem necessary.

As a reminder, these estimates include an expected increase in pension expense of approximately $0.35 per diluted share as the lower discount rate was required for accounting purposes.

So with that, I’m going to turn it over to Pam and she will get into a little bit more detail for you.

Pamela Huggins

Thanks Don. So at this time I’d probably just take a look at slide number six and I’ll begin by addressing earnings per share for the quarter.

Fully diluted earnings per share for the first quarter came in at the low end of the guidance at $1.57. This is a decrease of $0.34 or 18% versus the $1.91 from the same quarter a year ago. And just weighing out both components, the puts and takes of that $0.34 per yield, segment operating income accounted for $0.26 of the decrease and this is mainly due to international and the continued softness that we are seeing in that region that Don just talked about.

Below segment operating income are what we refer to as below the line items, impacted earnings per share and favorably by $0.09 and again, this is mainly due to the other category and it’s the result of the higher pension cost that we communicated last quarter.

Higher taxes impacted earnings per share by $0.02 and this is mainly due to the expiration of the tax extended bill for U.S. research and development credit and there also were some discreet items that were in expense this year and a benefit last year and then less shares outstanding impacted the earnings per share favorably by $0.03.

So moving to slide number eight, looking at the top line, revenue for the quarter, they were essentially flat, decreasing $19 million or 0.06%, coming in at $3.2 billion consistent with last year. Our revenues decreased in international and climate and industrial controls, offset by increases in North America and aerospace.

There wasn’t any impact to revenues as a result of acquisitions and currency and total acquisitions added 3% to sales, which was offset by negative currency of approximately the same amount.

Segment operating margins for the quarter decreased 170 basis points from 16.1% to 14.4%, again mainly due to international and aerospace. Please note that acquisition expenses and integration charges are included in these numbers. Parker incurred $0.01 in restructuring charges in the quarter and plans to incur $0.05 to $0.10 in fiscal year 2013 going forward.

Slide number nine, focusing on segments and commencing with North America, organic revenues increased 2% in the quarter, acquisitions added 3% to revenues and currency was relatively minor in this segment, as such reported revenues increased 5%.

Operating income increased from $223 million to $227 million, a 2% increase over the prior year and operating margins of 17.9% for the quarter decreased 60 basis points from the first quarter last year, however you should note that the first quarter of last year was an exceptional quarter with a margin of 18.5%.

Continuing with the industrial segment, moving to international, organic revenues decreased 6% for the quarter. Currency was a deduction to revenues in the quarter of 7%, again mainly due to the weakness of the euro acquisition that is 4% to sales and as such reported revenues decreased 9% for the quarter.

Operating margins decreased 330 basis points to 12.9% and this is down from 16.2%, again due to reduced sales in Europe, Asia and Latin America and the impact of acquisition related cost and of course currency.

And then moving to slide number 11 and focusing on aerospace for a moment, their reported and organic revenues increase 9% in the year as acquisitions and currency had minimal impact. Margins decreased 240 basis points for the year to sub quarter to 11.4% from 13.8% and this includes the higher non-recurring engineering charges and the higher OEM business for this aftermarket.

So moving to slide 12, climate and industrial controls, for the quarter four revenues were down 3% and unfavorable currency deducted another 2%, so as such reported revenues were down 3%. Segment operating margins as a percent of sales, in spite of lower sales increased to 9.4% from 8.2% a year ago.

So now moving to orders, I’ll quickly run through this for you. Slide number 13 detailed orders by segment and just as a reminder, these numbers represented trailing three-month average and are reported as the percentage increase of absolute dollars year-over-year and excluding acquisitions and currency, except for aerospace. Aerospace is reported using a 12-month rolling average, because of the lumpiness of that business.

And as you can see from this slide, orders declined 6% for the September quarter just ended, reflecting softness in North America, continued softness in Europe, China and Latin America, which resides in the industrial international segment.

North American orders for the quarter decreased 11%, industrial international orders decreased to 8% and aerospace orders increased 5% for the quarter, the climate industrial control orders increased 2% for the quarter.

So moving to the balance sheet, our balance sheet remains strong. Cash on the balance sheet at year-end was $436 million and $35 million in commercial paper was outstanding. DSI or Day Sales and Inventory remained at 62 days in fiscal year 2013 versus 2012 and this includes inventory that we added in connection with acquisition.

Inventory to sales of 11.3% compares to 11.4% in the same quarter of fiscal year 2012, so not bad performance on the inventory side. Accounts receivable in terms of day sales outstanding closed at 51days, 3 days higher than last year and the WADPO or what we call weighted average days payable outstanding increased to 55 from 54 last quarter.

Operations used cash of $7 million in the quarter, mainly due to cash contributions to the pension plans of $226 million. Other major uses of cash in the quarter are as follows: $169 million returned to the shareholders by a share repurchase, $108 million and dividend payments of $61 million. $195 million in cash utilized in connection with acquisition and then $77 million or 2.4% of revenues was used in connection with the capital expenditures. We’ve been saying for some time that it would get up to the 2.4% level and so we are seeing a sector that we’ve talking about for a while. And then net of these uses of cash, there was a positive FX impact of $39 million, so cash decreased $402 million in the quarter.

So on slide 15, here we have the debt to total cap ratio, 25.7% and on a net basis 20.7%, so we have lots of room to grow through acquisitions and organically.

So now I’ll move to the guidance, which is illustrated on pages 17 through 19 and on slide 17 the guidance for revenues and operating margins by segment, they have been provided there. I am not going to read through those here on the call, but they’ve been detailed on the slide for your convenience.

And then on slide 18, guidance has been provided in total for items below segment operating income and that’s $480 million at the mid point. The amount is higher than the prior year, but its used as a petition cost that we talked about on the last call.

Slide 19 summarizes the guidance on a diluted earnings per share basis and as you can see from this slide, the guidance for 2013 for earnings per share is projected to be $6.15 to $6.75, just as Don had mentioned earlier. The components of the changes in guidance have been detailed on the waterfall chart on this slide that you see now and this is reconciling the previous guidance of $7.50 to the revised guidance used in the midpoint of each.

So you can easily determine if that segment operating income on a per share basis decreases by $1.09 and that’s mainly due to the industrial segment of our business, below the line items at $0.05. Tax is a deduction of $0.05, less shares outstanding is a result of share repurchase and adds $0.04. So just as a reminder, the forecast, it doesn’t include any acquisitions that we may make in the next three quarters of this year.

The guidance assumes the following at the midpoint: increased revenue year-over-year minus 2%, that’s decreased revenue I should say; segment operating margins of 14.5%; expenses below segment operating income including corporate, admin, interest and other at the mid point of $480 million, with a band of plus or minus 2.4% and a projected full year tax rate of 28.5% and this is up from 28% in the previous guidance and I’ll talk about that in a minute, and then the guidance includes $0.05 to $0.10 for restructuring. I expected it to be on the high end. We talked about the $0.05 to $0.10 last quarter and we are now expecting the restructuring to be at the high end of that amount.

But a couple of tail end points with respect to the guidance. Sales first half, second half are divided 48%, 52%. Segment operating income, the first half and the second half is divided 44%, 56% and now getting back to the tax rate and why its going to be higher.

The company will recognize a gain in the second quarter from the sale of the automotive portion of the climate industrial control segment. We’ve excluded that from the guidance due to planned offsets that will occur in the second quarter, however the tax rate attire in the second quarter, because we needed to add the tax that’s related to that gain, as we don’t see an offset in the tax line in the second quarter as a result of the offset.

So you’ll see in the second quarter that the tax rate is about 200 basis points higher than it is in the third and fourth quarter and again, just to reiterate, that’s the tax on the gain from the sale of the portion of the climate industrial control business that we sold.

Earnings per share will be lower in the second quarter as revenues are lower, and again, this is consistent with the natural cycle of our business. We have more holidays in the second quarter and so our second quarter is I would say, our worst quarter of the year. That’s consistent from year-to-year for the most part and so don’t forget that as your working your model. The second half of the fiscal year is higher than the first half, and again, this is due to the natural cycle of the business. We have a 48%, 52% split.

So, at this time I think that pretty much covers the guidance and we’ll open it up to the standard Q-&-A.

Question-and-Answer Session

Operator

(Operator Instructions) And our first question comes from the line of Joel Tiss with BMO. Please proceed.

Joel Tiss - BMO

Well, I finally made it. Just two quick questions; one is a clarification I guess. Can you be more specific on the accretion or dilution from the sale of the CIC business, the auto part?

Pamela Huggins

Yes, I can. It’s about $0.04.

Joel Tiss - BMO

Okay, thanks. And then I just wanted to ask Don. I mean he’s probably the guy with the most experience on the call, unless Alex Blanton is on, and I just wondered, you’ve been through three or four recessions or whatever and you’ve seen how they developed and all that and I just wondered, like what do you see for the next year? What are your customers saying? Are we going into another recession or we are just slowing down or correcting inventories. Can you just take your whatever years of wisdom and help us out a little bit.

Don Washkewicz

Well, thanks Joel. Basically if you think back to the end of last fiscal and we started talking about this fiscal, which takes us half way into 2013, what we are hearing on the street at the time and from our customers and all that, keep in mind that for instance Latin America was pretty flat and had been flat for quite some time and we started hearing well, we are going to start seeing a little bit of a hick-up there, because we’ve been down and that’s on a month-to-month, quarter-to-quarter basis we’re going to start seeing some pick up, we didn’t see any of that.

The next thing we’ve heard was that Europe’s in the tank and which we knew. Last year they were, of course the whole Greece thing just continues on. I don’t know if that will ever be resolved, but it was all that malaise about what’s happening in Europe and who is the power. They are going to get their financial things in order and we heard that there was probably going to be some improvement there, we haven’t seen any improvement or actually we’ve seen and actually it’s gone the opposite direction.

Then lastly as you recall we talked about Asia, and we said, yes that stimulus is coming in China. The rail project is going to come back on, construction is going to probably pick up a little bit and in fact if you look at our China activity, it hasn’t really materialized. As a matter of fact, the GDP over there is more like in the low sevens now as opposed to what they were looking at before.

So as I look forward, do I see a cliff coming? I don’t see a cliff. It just seems like, just like a flat lining if you will, waiting for something to happen. Its not like what happened a couple of years back in ‘09 when we had the housing crisis and all the sub prime crisis and so forth going on. I don’t see that happening, but I just don’t see any more right now as we were hoping to see. Some positive movement in any of these markets overseas and that’s any of these regions around the world.

So what we decided to do here is just say, hey, lets not assume anything at this point. Lets just assume this current situation continues as is. We don’t see anything where its going to like be a cliff going forward, but at least for the rest of our fiscal year, I haven’t heard anything that would change my opinion that we are going to change the current picture, all that dramatically. Something might happen after the elections, who knows. I mean, its anyone’s guess as to what might happen after November, but we are just assuming that its kind of flat line from here to the rest of the way out and that’s kind of the way we are playing it here.

We are taking a number of actions internally to adjust to that reality and we are doing all the prudent things that we’ve done in the past with respect to our workforce adjustments and CapEx rebalancing and things like that and we’ll continue to look at that.

So we’ll get another look at the end of the calendar year. Probably have a better vision of the third quarter and fourth quarter then. I would say, based on what we are seeing right now, at this point I don’t think there will be much change, unless something dramatically happens in one of these regions.

Joel Tiss - BMO

All right. Thank you very much.

Don Washkewicz

Sure.

Pamela Huggins

Thanks Joel.

Operator

Our next question comes from the line of Stephen Volkmann with Jefferies. Please proceed.

Stephen Volkmann – Jefferies

Hi, good morning.

Pamela Huggins

Good morning.

Stephen Volkmann – Jefferies

I was wondering if you could just give us a little more color, I guess on the North American orders. That was the one that was kind of surprising for me, and Don, you sometimes have your sort of 3/12, 12/12 commentary that you do by end market. I am wondering if maybe that might help us understand that?

Donald Washkewicz

Well, let’s talk a little bit first about just a couple of other indicators. Now one thing, when you look at it, I like to look at the PMI indices, because that’s kind of telling as to what’s happening there.

First of all, all of the PMI’s pretty much globally have been going up interesting enough, in spite of what we’ve been just talking about here, but only North America is greater than 50%. So that’s kind of telling us, well everything seems to be moving a little bit in the right direction, but nothing other than North America is really in a positive territory with respect to the PMI.

When we look at the specific market segments and what’s happening there as far as order trends, which ones are doing better and not as good, pretty much all of the aerospace markets, both military OEM and aftermarket segments are all looking good on a quarter-to-quarter comparison; that’s what I am going to kind of give you here is the kind of the overall trend.

Some of the other ones that are looking good, power gen process markets, farm and ag has been positive and I think that will continue, oil and gas has been positive and commercial refrigeration. If we look at our trends, those would be the positive ones. The ones that are kind of flattening out for the most part, but not necessarily terrible, but it’s just that they are not growing at the same rate they had been in the past would be cars and light trucks distribution, semiconductor, life science and heavy-duty truck. I mean this is not to say those are doing real bad, it’s just that the trends are actually flattening out on those.

Then regionally if we look at the regions as well, as far as the trends both the 3/12 cyclical and the 12/12 cyclicals, right now North America, the 3/12 is a little bit below 100%, which would mean that the North American markets are coming in for a soft landing, kind of flattening out, which we kind of have been seeing here so the 12/12 is still north of 100, but heading toward 100% on a year-to-year basis.

Europe is running around mid-90’s on a 3/12, which is basically pulling the 12/12 down into the mid-90’s. So that would be the worst region for us worldwide, that’s real weak. Asia, we have basically a 3/12 and 12/12, that’s just slightly below 100%, so pretty flat. Asia pretty flat at this level, this is flat to slightly negative.

Latin America, the 12/12 is running just under 100%m so again it’s still weakest as well. So really with the exception of North America, the rest of these regions are weak, Europe being the weakest for us.

I could go on to specific end markets, but I just wanted to give you that basic color there. One other thing that just to give you maybe another bit of information, our backlog, this would be our total backlog for the company. In the first quarter it decreased 2.5% year-on-year and that’s for the total company, that includes aerospace.

If you look just at the industrial part of the business, the backlog decreased by 8%, so that will kind of give an indication. Again, that activity or those numbers Pam already covered as to where that was coming from. So hopefully that helps you a little bit.

Stephen Volkmann – Jefferies

Great. I appreciate that, and maybe just quickly, just your thoughts on share repurchase given the liquidity you have on the balance sheet and the cash flow that you seem to be doing this year.

Donald Washkewicz

Well share buyback, currently just to remind everybody, we increased our 10b about a year ago, 10b5-1 from about $50 million a year to $200 million. So we are around $200 million a year, about $50 million a quarter pace right now, so that will continue.

We bought in the first quarter I believe somewhere around 57 million shares back in the first quarter and that would give you about $107 million in the first quarter total for the company.

What I have been doing, not just I, but what we have been doing is really focusing primarily right now, trying to keep enough dry powder to go after some of these acquisitions that are in the pipeline. You can see that we picked up five. We’ve got a couple of more coming through in this quarter. So we’ve been just kind of are these going to make it at the finish line or not. If they are, we’d like to maintain, have some capacity to do some of these acquisitions, not all of them we realize are going to make it to the finish line.

Then after that if in fact they don’t, we’ll buyback more shares, but I don’t want to predict at this point just what we are going to do. I’d say the preference right now, because we’ve been working on some of these acquisitions is to try to get some of these closed in the balance of this fiscal year.

The other thing that we are going to do, of course we are going to continue to do would be the dividend payout; we want to continue that. We have an increased record that goes from 56 years now and we are pretty happy about the yield where it’s at. We are approximately at the median of our peer group, around 2% yield and we might need to tweak that a little bit. Of course if the stock drops further, we don’t have to worry it’ll be higher than 2% yield, but we hope that doesn’t happen.

In acquisitions, not acquisitions, but in other growth areas like supporting capital expenditures, we are still looking at around 2.5%. I think Pam mentioned around 2.5% and we are still looking at that as far as capital allocation.

So hopefully that answers and I can’t give you a hard number on share repurchase of course. We’ll look at share repurchase in light of the acquisitions that we are looking at and if we have capacity there and the shares are suppressed, we’ll definitely do more share repurchase.

Stephen Volkmann – Jefferies

That’s great, and I don’t want to put words in your mouth Don, but it sounds like what you’re saying is the acquisition pipeline is fuller than it’s been for a while. Is that accurate or it might mean too much.

Donald Washkewicz

I think that’s very accurate. It seems like it took a longer time to fill it this time around, because we’ve been talking about it for a long time that we are looking at a lot of things. It seems like the fluid is moving a little slower through the pipe, but they are starting to coming out the other end, so that’s good and it’s encouraging, because we’ve picked up some very nice acquisitions off late.

Stephen Volkmann – Jefferies

Thank you very much.

Pamela Huggins

Thank you.

Operator

Our next question comes from the line of Eli Lustgarten with Longbow Securities; please proceed.

Eli Lustgarten - Longbow Securities

Good morning everyone.

Pamela Huggins

Hi Eli, how are you?

Eli Lustgarten - Longbow Securities

Just had a clarification, your EPS guidance assumes what share count for the year? Is it probably the easiest way for us to do it?

Pamela Huggins

About $1.54.

Eli Lustgarten - Longbow Securities

About $1.54. So you actually don’t expect the net…

Pamela Huggins

I am sorry, $1.53, I apologize.

Eli Lustgarten - Longbow Securities

You were just about $1.526 I think for the quarter. So you’re assuming there’s no net share reduction for the rest of the year?

Pamela Huggins

That’s right.

Eli Lustgarten - Longbow Securities

Okay, and the guidance for revenue includes the $380 million of annual sales that you’ve announced in the first quarter and it’s all in there.

Pamela Huggins

That’s right. Just so you know though, let me just give you some numbers here, in terms of the acquisitions. It’s about 2.5%, 2.4%, 2.5% of the sales amount. Okay?

Eli Lustgarten - Longbow Securities

Okay. I mean you are indicating that profitability, I guess as the volume comes down, you are going to be able to hold profitability in Industrial in North America for the last year. In other words, you don’t expect to go much under 17%, I would suspect for the rest of the quarter despite the lower volumes? And in aerospace, the increase of profitability comes from lower R&D or better volume or better mix or what’s…

Jon Marten

Well, in terms of the aerospace Eli, it is really both. It’s the R&D that Don talked about earlier and just us trying to react to some of the programs that we won over the last five years and a little bit of a change there in terms of our forecast going forward and also again…

Eli Lustgarten - Longbow Securities

How much was the R&D increase in the quarter unexpectedly for us?

Jon Marten

About $0.02. And then the other part of the change in the guidance is in the mix and it has to do with the commercial MRO business here. Its not quite as robust as we had planned, slightly down.

Eli Lustgarten - Longbow Securities

Okay, and the profitability in both industrial North America and industrial international going forward, I guess you are saying it’s going to come down to like this operating margin in North America to stay the same, and international from where we are today?

Jon Marten

I would say that’s North America is staying, industrial is staying north of 17% and international gradually improving throughout the year.

Pamela Huggins

Right, and one thing to be aware of the way the currency impacts, it gets more favorable as we go throughout the year.

Eli Lustgarten - Longbow Securities

Okay, and one final question is that we talked about the drop in orders and so, can you talk about inventory liquidation at distributors. Are we seeing – like they were saying, that we are starting to hear and talk about it and particularly as construction equipment and I am surprised heavy truck is flat, because the production is down 20% in the fourth quarter, but has construction equipment taken down their orders also across the board?

Donald Washkewicz

Yes, that’s the segment that we’ve seen the most adjustment in, is the construction equipment, the OEM segment. A lot of the OEMs readjusting there and I think that’s pretty much globally too by the way, its not just North America, it’s pretty much globally, that, what we are seeing in the construction segment or part of the business.

Eli Lustgarten - Longbow Securities

And distributor inventories are…

Donald Washkewicz

Yes, the distributors, I wouldn’t say distributors Eli are probably reacting from what input we are getting, pretty much like they have in the past. Pretty much haven’t been building a lot of inventory to begin with. So they are basically adjusting to the reality like we are. I don’t see any huge material changes one-way or the other. I think they are going to gradually making adjustments as times go forth. Keep in mind that there is no cliff that we see on the distribution part of the business either, see that’s still a pretty solid segment for us.

Pamela Huggins

Eli, we need to be cognizant of time to give other people a chance. Thank you.

Operator

Our next question comes from the line of Rob McCarthy with Robert W. Baird. Please proceed.

Mick Dobray - Robert W. Baird

Hello, this is Mick Dobray in for Rob McCarthy, good morning.

Pamela Huggins

Good morning.

Mick Dobray - Robert W. Baird

So first, a quick question on Industrial and International. Can you give us a little more color on the integration acquisition cost in the quarter?

Jon Marten

Well, for the Industrial International segment we are seeing a $0.03 for the integration and acquisition cost. This relates to deals that we have announced and completed in Q1. This also relates to deals that are unannounced and that are in the pipeline that Don has been referring to.

Mick Dobray - Robert W. Baird

Okay, great, thank you. And then switching back to industrial and North America and you commented a little bit about the Parker stores, but I’m wondering, are you seeing going forward any sort of mix shift in the way your revenues are generated in that segment.

And what sort of impact did you bake into your margin assumption? Because from what I can tell, your incremental margin embedded in the guidance is something north of 35% in North America. So I’m kind of wondering, is it that you are sort of seeing a more pronounced shifted on the distributor side or is it that its OEM business that potentially carries higher margin there.

Pamela Huggins

I just would like to make a comment about this marginal return on sales at this point. There are certain points in the cycle when you don’t have a lot of acquisitions, you can look at these marginal returns on sales number and they make a lot of sense. But then there is points in the cycle and especially a period like this when we are doing a lot of acquisitions.

These marginal return of sales numbers, there is the law of small numbers, number one. And then also due to the acquisitions they can become a little distorted, and if you look at North America, just to give you an example, the marginal return on sales in the first half is, you’re right, north of 35%, but if you look at the first quarter and the second quarter, you have a favorable 6% and then a unfavorable 24% in the second quarter, so it’s just the way the numbers are working out.

For North America, quite frankly we’re right in line where we think we should be.

Mick Dobray - Robert W. Baird

Okay, thank you.

Operator

The next question comes from the line of Alex Blanton with Clear Harbor Asset. Please proceed.

Alexander Blanton - Clear Harbor Asset

Hi, can you hear me?

Pamela Huggins

Yes, good morning Alex.

Alexander Blanton - Clear Harbor Asset

Thank you. Hi Joel. You asked the question I was going to ask and I want to go back to that for a minute. No one has really focused on the 11% decline in North American orders in the quarter and that apparently really started in September, was the first two months up in September more than offsetting, and what does this mean in terms of the economy for the fourth quarter, what do you think?

Pamela Huggins

Well, let me just give you a little color on how things played out through the quarter. As we went into July and then August, we were feeling pretty good, because we were right on pace with what we had told you previously. It’s really the month of September that really did take a big decline.

Alexander Blanton - Clear Harbor Asset

So, it was more than offsetting. In other words, it was down more than the first two months were up?

Pamela Huggins

Yes. For the quarter, you can actually look at the miss. We did a $1.57 for the quarter; we thought we were going to do around $1.66. It really was attributable to the really tough September month.

Alexander Blanton - Clear Harbor Asset

Well, now doesn’t this sort of indicate we might be entering a recession here, a big fall off in orders in September and the weakness overall in other companies results that are coming along here as we go through the earnings season? I’m just wondering why you are assuming it’s going to be flat for the year when you are starting the next nine months with a big downturn in your orders.

And secondly on that question, how do you think the election is going to affect you? I mean, depending on who is elected, you might have a big increase in the business in the second half or a big decline. So are you just waiting to see what happens or do you think it doesn’t matter?

Donald Washkewicz

Maybe Alex I’ll just touch on -- this is Don, I’ll touch on the second part of that. We can’t predict what’s going to happen frankly. We have our own opinions as to what would be best for the economy and best for our business certainly as to outcomes, but I don’t want to go online and predict anything.

I think instead of doing that, we just decided not to predict anything, and just say, hey we are going to get another look at this after the beginning of the year. We’re going to know lot more then. We feel pretty comfortable with our second quarter; you can back into our second quarter numbers. We’ve given enough information. So you can back into that and we feel pretty confident on those.

And when you look at October, the way it’s coming in right now, I mean October is usually a pretty good month and its shoring up to be reasonably good month, so that’s going to carry a big portion of the second quarter, because remember November, December are the weakest months in the quarter. So had we not had indication of a reasonable October, we would be telling a different story right here, so okay.

Alexander Blanton - Clear Harbor Asset

Okay, yes, I got that. Okay listen, I don’t want to take too much time, but I’ve got another question on your international business, you had a 50% decremental margin. Operating earnings were down $56 million and sales were down $112 million. So why was this so large on decremental side?

Jon Marten

Alex, Jon here. Just to try to help you with that. Internationally, first we talked about the acquisition integration and acquisition costs. So that $0.03 that we’ve talked about are baked into those MRO this year for Q1.

In addition to that, as you know we try to manage to negative 30. That’s historically in the best times. When we are actually going down we, are able to manage the negative 30 and that provides a very good result from us, from a margin or return on sales.

When we first start turning though, as we are turning right now, we can’t react instantaneously and so we are furiously throughout all of our operations, specifically in this case internationally that we are talking about working to try to take the actions that are necessary in order to adjust to the new reality that we are seeing here in terms of the recession in Europe in most countries there, as well as the reduced industrial production indexes that we are seeing from Asia, primarily in China.

Alexander Blanton - Clear Harbor Asset

Yes, so you try to get a 30% decremental margin, but you can’t react that fast, right?

Jon Marten

Right, right. So, we don’t expect that 50 to continue and we are determined to get to no worse than negative 30.

Alexander Blanton - Clear Harbor Asset

And that 30 would be lower, but you don’t want to cut out all of the SG&A that you built up necessarily, right?

Jon Marten

Well, we’ve got a certain base that we will continue to maintain and we will continue to try to structure all of our operating divisions in a way that is going to make us also able to be able to react as things go back up. So we’ll be mindful of the long-term, we’re not going to be totally short-term focused.

Alexander Blanton - Clear Harbor Asset

Okay, thanks.

Operator

Our next question comes from the line of Andrew Casey with Wells Fargo. Please proceed.

Andrew Casey - Wells Fargo

Thanks and good morning everyone.

Pamela Huggins

Good morning.

Andrew Casey - Wells Fargo

At the risk of beating a dead horse, I just wanted to ask Joel and Alex’s question a little bit differently. From a historical context, could you discuss whatever differences you may be seeing between what happened in September in industrial North America, the order drop-off from what you historically saw back in fiscal Q2 ‘09?

Jon Marten

Andy, Jon here. One thing that we’ve been looking at very closely is and talking about is of course as we are putting the guidance together here. How does this situation compare to prior years and we are very intensely looking at the data in each one of our groups and each one of our segments.

One of the things that Don talked about earlier, I think it’s very important for you and Alex and Joel and everybody to remember is that we did experience several cancellations from some of our OEM customers and those cancellations of course are one-time events. They are not a general pattern. They were enough for us to mention in our comments going forward and so as we experienced those cancellations they’ll have a one-time impact on our order rates for a quarter, but we don’t see, especially given the detail that we know behind the order reductions, we don’t see that impacting us going forward at the same rate.

So what we do as you know is, we took our bottoms up approach in our forecast when we put our guidance together. We feel very good about our Q2 and our balance of the fiscal year based on what we know right now, and that is how we basically have looked at this question of the orders in the month of September and the impact on North America for the quarter.

Andrew Casey - Wells Fargo

Thank you for that Jon. So if I could take a stab at re-characterizing what you just said, is your view that the OEM customers in particular who made those cancellations are just taking deep production cuts right now to true up their order boards? Is that…

Jon Marten

Yes, I think that they are resetting, there is no doubt that they are resetting and we are reflecting that in our results and keep in mind that as Don talked about the PMI moving up in North America, many of our customers that reset their orders in the quarter are also resetting their look to react to the international situation and sometimes those orders are going to our OEM customers in North America, but ultimately are destined for final demand that is international related.

Andrew Casey - Wells Fargo

Okay. Thank you very much.

Pamela Huggins

Thank you.

Operator

Your next question comes from the line of Jamie Cook with Credit Suisse. Please proceed.

Pamela Huggins

Good morning Jamie. How are you doing?

Linda - Credit Suisse

Oh! This is actually Linda in for Jamie.

Pamela Huggins

Oh! How is Jamie doing by the way?

Linda - Credit Suisse

She is doing well.

Pamela Huggins

Good, good. She just had a baby by the way.

Linda - Credit Suisse

I mean kind of going with what everyone else has been asking with those orders in the U.S. I mean those cancellations, how is that making calendar year 2013 looking for you. Like OEMs, are they looking at sort of a growth year or is that going to be more flat looking or down. Like what’s sort of your expectations with dealer orders?

Donald Washkewicz

This is Don again. I think if we see that happening on an ongoing basis, then it’s going to bode not so well for 2013. But like we said earlier, we’re seeing this adjustment and I think this is just adjusting like we are adjusting to the current reality and I don’t see it continuing.

At least at point if the global condition worsen, and then I think maybe there’s going to be another readjustment. But I think that’s how it will affect us over the long period. I don’t see any sustaining effect of what we saw in September above and beyond what we’ve already indicated in our guidance.

Linda - Credit Suisse

Okay, and then switching over to international then. I mean China seems like it’s kind of an important part of the international recovery. What is your thoughts on China? I mean, is growth going to come back there next year or is that pushed out to your fiscal years 2014 or how is that kind of looking?

Pamela Huggins

It’s Pam Huggins speaking. Really we’ve become, I don’t want to say negative, but versus what we were thinking even three months ago, our view is somewhat different. We were probably a little exuberant in what we thought might happen in China, but we were right in line with that everybody else was thinking at the time too.

We thought we would see more of an up-tick there actually now. We do have the little bit of growth baked in, but it’s very minor, 1% to 2 % in the second half, and I would call that probably more in line with the natural cycle of our business, than really seeing any true up-tick that’s going to take place there.

Linda - Credit Suisse

Okay great. Thanks guys.

Pamela Huggins

Thank you.

Operator

Our next question comes from the line of Nathan Jones with Stifel Nicolaus. Please proceed.

Nathan Jones - Stifel Nicolaus

Good morning everyone.

Pamela Huggins

Hi Nathan.

Nathan Jones - Stifel Nicolaus

Can we just talk a little bit about Europe and kind of the sequential progression there, things still deteriorating sequentially stable, getting any better?

Jon Marten

Well, I think if you look at what’s happening from some of the PMI’s that I had mentioned earlier, which is probably the best indicator overall. I mean we can talk about our own numbers and all that, but the Europe is negative, I mean negative to 50%, they are down around 45%, 46%. They creped up a little bit in September.

Germany actually bounced up about three points, so they are around 47%, which is a good indicator. So I don’t think deterioration from this point as what I’m seeing here. I just don’t see a tremendous up-tick either. I just see more of a steady as she goes.

Nathan Jones - Stifel Nicolaus

And could you talk about specifically your own business over there and how that progressed through the quarter?

Jon Marten

Nathan, as the quarter went on, it was obvious to us that in Europe we were bouncing along a low level, and so we don’t see further deterioration through the quarter. Our projections through the balance of the year are that we are basically flat lining and flat lining in terms of the growth that we had projected in the first sort of the guidance at the rate that we are now seeing.

And Nathan, we are in a low level there. We’ve never gotten to the point that we really have been able to see a huge growth in the different end markets that were in there that are opposed to some of the other end markets around the world.

We are really focusing in on some of the growth opportunities that are in very strong end markets that are in Europe right now; one of them being oil and gas process, a few other chemical industries that are really very promising for us. But the short answer to your question; we are at a low level, but we are not deteriorating further and that’s what our guidance indicates.

Nathan Jones - Stifel Nicolaus

Okay. And it sounds to me a little bit like the drop-off in orders in Industrial North America might be primarily driven by end market weakness in Asia. Is that a fair statement?

Jon Marten

I think that certainly some part of that is attributable to that. It’s really hard for me to tell you what part of it, but that is certainly a material portion of the answer and again, we are looking at it as a reset and we are looking at our customers reacting to their ultimate demand levels and many of our customers are multinationals too as you will know.

Nathan Jones - Stifel Nicolaus

And if I could just slip one more in on aerospace, are you expecting the OE versus MRO mix in the balance of the year to be the same, more heavily skewed to original equipment or more heavily skewed to MRO?

Jon Marten

As time goes on through the year, it’s going to be more heavily skewed to OEM.

Nathan Jones - Stifel Nicolaus

Great. Thank you very much.

Operator

Our next question comes from the line of Jeff Hammond with KeyBanc Capital Markets. Please proceed.

Jeff Hammond - KeyBanc

Hi guys. You mentioned a lot of kind of acquisition and integration cost, but clearly you are bringing in some good businesses. I mean how should we think of – I mean, do these start to become accretive pretty quickly or I mean, may be if we look at the whole year, how should we think about accretion from these deals?

Jon Marten

All of these deals that we announced in Q4 last year and in Q1 this year have been accretive, accretive to the bottom line and are performing very well for us. We are very excited about the prospects and of course we’ve got integration cost and things, but even given that these deals have been accretive.

Jeff Hammond - KeyBanc

Okay, but your bridge doesn’t really call out any acquisition positives or negatives?

Jon Marten

No, we just don’t get to that level of detail and we normally don’t go deal by deal and explain exactly what the performance has been by quarter, but in general, we wanted to make sure that we explain to you and anybody else in the call that deals have been accretive for us and we are happy with the results that we are seeing.

Jeff Hammond - KeyBanc

Okay. And then Don, I just want to understand the capital allocation dynamics a little bit better, because I think what you are saying today is acquisition pipeline is pretty full and we are going to focus more on deals. Yet, the last two quarters your comments were, I want to buyback my stock, I want to buyback my stock and now the stock is down 7% today, and looks like maybe a better buy than the previous quarters, I mean what’s really changing here?

Donald Washkewicz

Nothing’s changing, it’s a timing thing. Like I said the pipeline takes a while to fill. Once you get things going down through the pipeline, it’s a timing issue. When those start coming out the other end, I have to have money to pay for. If they are not going to come out the other end or if they are going to come through slow, then I can maybe do some share buyback and replenish my dry powder in the interim. So it’s really a matter of timing as far as what I can do and how much I can do, when I can do. We’ve done a lot of share buyback in the last couple of years. I mean a $1 billion type numbers. So it’s not like we’ve been sitting here doing nothing.

We weren’t able to do as many deals in the last couple of years, because we are filling the pipeline, we are looking at things, we are turning some away, we are looking more seriously at some. So I think it’s really a timing issue and we look at kind of real time all the time, like okay, how much money do we have, what’s our leverage, we are not going to let our leverage go above 37%. We are going to maintain our A ratings on our debt. So what can we do and how much can we do; when can we do it?

Of course, if I knew that the stock was going to drop $7 today, of course this would be a great buying opportunity and it is a great buying opportunity, and I am not going to predict anything here, but I say that we are certainly looking at that in light of everything else we’ve got coming through the pipeline.

But once I get things going through the pipeline, and get them going through a due diligence process, I can’t just shut that off. I mean it would be silly to do that. We spent a lot of money to get them to that point. So we’ve got to continue through with the ones that we are looking at seriously and we are always looking at Parker’s stock as a good potential acquisition for us and certainly at these levels that it’s at now, it’s a tremendous opportunity.

Jeff Hammond - KeyBanc

Okay, thanks.

Pamela Huggins

Okay, we’ll take one more call or one more question at this time please.

Operator

Our last question comes from the line of Henry Kirn with UBS. Please proceed.

Henry Kirn - UBS

Hey, good morning guys.

Pamela Huggins

Hi Henry.

Henry Kirn - UBS

How quickly can you flex production? could you discuss a little bit the changes to your headcount plans over the last quarter and then maybe if the OEMs were to switch back to a more positive view, how quickly could you shift the production back up?

Donald Washkewicz

That’s a good question Henry. I think one thing that we are doing is adjusting the workforces globally. It’s slower in Europe. Probably the slowest of any region around the world is Europe because of all the workers council negotiations and the government negotiations that go on when you are trying to reduce workforce or adjust it down and so what we’ve done over time, is we’ve built up a layer of what we call associates part time employees and so forth, so that we could flex better and that’s what we are kind of working into right now as these associates, where you can take actions a little bit quicker and adjust a little bit faster and yet not eat into your core workforce, so that’s kind of what we are working on.

The other thing that we’ve done as we gotten some locations, we have shortened work weeks. Again, every facility -- we have about 350 facilities, so everyone is in a different state as far as demand and order trends and so forth. So they are adjusting with short work weeks, part timers and associate workers and so forth. Those are the kind of things we are doing in the workplace.

I think we are going to be in a tremendously good position to rebound whenever there happens to be a rebound and hopefully that’s soon here. There is certainly a possibility it could be soon. So we are ready, we can add people back, we’ve got the core workforce still there, so that we can respond quickly to any changes in demand.

Pamela Huggins

Okay. At this time, we’d like to end the formal Q&A session and I’m going to turn it over to Don who just has a few closing comments. But for those of you on the call, I just want to say thank you. I know that you guys have had a very busy day today; a lot of people releasing earnings this morning. So thank you for taking the time to attend our call.

And with that, I’ll turn it over to Don.

Donald Washkewicz

Well, I want to once again thank everyone on the call for joining us this morning and I also want to take the opportunity to thank all of our employees as I have in the past for their continued commitment and our success. The team continues to execute on our win strategy and they continue to outperform and perform extremely well vis-à-vis our peer group.

Throughout this period of uncertainty we are going to continue to manage our cost as we said on this call. We are going to maintain our strong financial position as I stated with our leverage and we are going to continue to pursue our long-term growth strategy and we’ve talked about all of those issues today.

So I want to thank you again for your participation on the call and for your continued interest in Parker. As we’ve said in past, Pam will be here the balance of the day and she will be taking calls. If you have anything that we haven’t answered, feel free to give her a call today. Thank you very much and have a good day.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. Everyone may now disconnect and have a great day.

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